The DiDi Dilemma and China Share Classes
Gene Reilly, Greenwich Quantitative Research's Chief Investment Officer, speaks with Leyla Gulen about the DiDi Chuxing dilemma and China share classes.
Leyla Gulen (00:00):
Hello and welcome. I'm Leyla Gulen. I'm the co-host of Quantitative Investment Insights, presented by Greenwich Quantitative Research. Greenwich Quantitative Research is an Asia Pacific market neutral quant fund and the founders have experienced trading Chinese stocks going back two decades.
In this episode, Gene Reilly, the Chief Investment Officer of Greenwich Quantitative Research is here with me, to discuss the variety of Chinese listed equities from onshore China to New York listings. As we will learn, there are many more types of share classes for Chinese companies compared with companies from other countries and this often leads to some confusion.
Well, at high level for various historical reasons, Chinese companies have had a variety of options for issuing shares on domestic and international exchanges. The list includes A-shares and B-shares in Mainland China. H-shares in Hong Kong, N-shares in the US, L-shares and S-shares in London and Singapore.
Well, due to policy changes in China, US listed Chinese tech companies have been in the news a great deal over the past year and investors are certainly familiar with those headlines. DiDi, the world's largest ride share haling company surprised investors by announcing on December 3rd, just five months after its IPO, that it will delist from the New York Stock Exchange and pursue a listing in Hong Kong. DiDi fell sharply in the news. Well, the stock is down over 80% from its IPO price.
Before we discuss the types of share classes in more detail, it would be great to hear what is happening with DiDi, Gene.
Gene Reilly (01:45):
Leyla, thanks so much. Thanks for that great introduction. DiDi was a very large IPO so its significant decline made it one of the biggest IPO losses for investors anywhere at anytime. DiDi raised $4.4 billion making it the second largest US IPO by a Chinese company. And a valuation at launch of approximately $70 billion. So we're looking at a material loss of market capitalization.
The largest US share sale by a Chinese company previously was Alibaba in 2014, $25 billion. DiDi started trading on the New York Stock Exchange on June 30th. But there were already signs of potential issues by mid June.
Leyla Gulen (02:29):
What happened in mid June?
Gene Reilly (02:32):
There are a number of conflicting accounts about what actually happened. Everything was happening in the context of a rapidly changing stance by Chinese regulators on large technology companies like Alibaba and Tencent, for example. There was a report on June 16th that the State Administration for Market Regulation was investigating DiDi's pricing and competitive practices. Subsequently, there were several reports that DiDi's management was explicitly requested to delay the IPO to give Chinese regulators time to review their data policies and business practices.
Leyla Gulen (03:04):
So as we know DiDi, did go ahead with the IPO. What do you think their management's thought process was?
Gene Reilly (03:11):
Based on a variety of reports, DiDi's management was weighing pressure from their investors for a liquidity event along with the impact of regulatory concerns. In hindsight, it's obvious that the decision to pursue the listing before the regulatory inquiries were resolved, was a mistake.
Leyla Gulen (03:28):
Well, on July 6, just four trading days after the listing, DiDi fell over 19%, just in one day. So what caused such a sharp drop?
Gene Reilly (03:39):
On July 4th, the internet regulators ordered app stores to remove several of DiDi's apps. The internet regulators cited DiDi's violations on collection and use of personal information and added it was investigating DiDi to protect the Chinese national security and their public interest.
New users were prevented from registering on the DiDi platform. Existing users were allowed to continue using the app. This was an unprecedented regulatory reaction by the Chinese authorities. In addition, the Chinese regulators announced that they would tightening roles for Chinese companies seeking to list or sell shares overseas.
Leyla Gulen (04:14):
What are the future of policy implications of what happened to DiDi?
Gene Reilly (04:18):
Shortly after the announcement on DiDi, the Cyberspace Administration of China implemented a policy that will require all companies holding personal data on a million or more users to apply for a cybersecurity review before any foreign listing. So the defacto outcome is, it will be much more likely large Chinese tech companies will list in China or Hong Kong.
Leyla Gulen (04:39):
And what happened next with DiDi and the regulatory review?
Gene Reilly (04:43):
It became significantly more intense. On July 16th, policy makers sent security and police officials to DiDi's headquarters in Beijing to conduct an onsite investigation that is still continuing, right now.
Leyla Gulen (04:56):
How is DiDi planning to resolve the regulatory issues?
Gene Reilly (04:59):
DiDi announced on December 3rd, it would start the process of delisting from the New York Stock Exchange and prepare to list in Hong Kong. DiDi also stated that it's US shares would be convertible into freely traded shares of the company, on another internationally-recognized stock exchange, after that was approved by a shareholder vote.
Leyla Gulen (05:18):
So DiDi sold off sharply on the delist news, even though DiDi stated its plans to relist in Hong Kong.
Gene Reilly (05:24):
Yes. DiDi sold off over 22% on December 3rd, on the news. There was a high degree of uncertainty of what's going happen with DiDi in the future since the details are minimal at this time.
Leyla Gulen (05:35):
DiDi has indicated that they would like to list in Hong Kong but what are the other options available to DiDi is it does delist?
Gene Reilly (05:42):
DiDi can do a share buy back and take the company private. They can delist from the New York Stock Exchange and the stock could trade OTC in the United States, while that's highly unlikely. And DiDi could list on another exchange, and investors who still hold DiDi in the US could do a share conversion.
Leyla Gulen (05:57):
What are the issues for US holders, for DiDi related to a delisting in the US and a listing in Hong Kong?
Gene Reilly (06:03):
Dual-listed stocks are completely fungible. Feedback from managers who have done conversions, is the process is easy. If DiDi can achieve a Hong Kong listing, it should be a straightforward process. Some of China's large tech companies are dually-listed in Hong Kong and the US, such as Alibaba, Baidu, JD.com and NetEase. So it's definitely possible.
However, it's not entirely clear that DiDi meets all of the Hong Kong listing requirements. It's been reported that DiDi looked at the Hong Kong listing two years ago but didn't meet the requirements at that time. However, a Hong Kong listing looks like the only option to resolve the regulatory inquiry and return some shareholder values. So consensus is, there will be a way found to get it done and to list the stock on the Hong Kong Stock Exchange.
Leyla Gulen (06:51):
Do companies that are already traded on a major exchange have different options to choose from for listing in Hong Kong?
Gene Reilly (06:59):
Yes. There's basically three options. you could do a secondary listing, a dual primary listing or a listing by introduction.
Leyla Gulen (07:05):
And you can explain how these might work for DiDi?
Gene Reilly (07:08):
Right. Although, the requirements for a secondary listing are less stringent than a primary listing in Hong Kong, a secondary listing isn't an option for DiDi because companies need to have been traded on another exchange for at least, two years.
A dual primary listing means there would be equivalent listings in both exchanges but that's not, an option for DiDi. Listing by introduction entails transferring existing DiDi shares from the New York Stock Exchange Registry to the Hong Kong Share Registry. No new shares are issued. The requirements for this listing are less strict.
It appears that DiDi intends to use listing by introduction according to people who are familiar with the matter. DiDi's appointed Goldman Sachs, China Merchants Bank, and China Construction Bank to manage the Hong Kong listing. Bankers have already met with the Hong Kong Stock Exchange and are working on a solution to make sure DiDi can meet all the listing requirements.
Leyla Gulen (07:57):
So this really raises the question of, when an investor buys a Chinese stock solely listed in the US, what claim do they actually have on the ownership of the company?
Gene Reilly (08:08):
It's a legally complex question. When a company is solely listed in the US by what's known, as a variable interest entity, which we'll discuss a little later, the issues around ownership are the most complex. Ownership rights are much more straightforward for convertible dual-listed shares that are listed both, in Hong Kong. For Chinese stocks, stocks solely listed in the United States under a Cayman VIE structure are just much more complex.
Leyla Gulen (08:37):
Given the sharp sell-off in DiDi, right after its IPO along with the policies from China, was there any commentary or action from US financial regulators? And protecting US investors, I would imagine must be a concern?
Gene Reilly (08:51):
Yes, this is a major concern, and, comes back to your earlier question of, what claims do you have on a company when you're purchasing something via a variable interest entity. So yes, the SEC has shown great interest.
In late July, the SEC permanently halted all IPOs from Chinese companies, given the regulatory uncertainty. The SEC is particularly focused on companies that use a variable interest entity structure to list in the US from China. The SEC is concerned that investors aren't really aware of the complexity of the structure when they buy a stock with a VIE company behind it. The SEC wants companies to explain clearly that investors are not buying shares of a company headquartered in China, rather they are buying shares in a Cayman entity.
In addition, Chinese companies using a VIE structure need to explain in more detail the relationship between the Cayman entity and the parent firm.
Leyla Gulen (09:44):
Okay. Well, let's talk about this now. What is a variable interest entity?
Gene Reilly (09:51):
A variable interest entity is a structure that allows an offshore entity via a contractual arrangement to control and receive the economic benefit of an onshore business. However, the contractual arrangements do not include ownership of the onshore business. The offshore entity is a company usually in the jurisdiction such as the Cayman's.
Leyla Gulen (10:12):
Why is there a need to set up such a complex structure? Why can't the Chinese companies list standard ADRs?
Gene Reilly (10:22):
VIEs have been used by Chinese companies for two main reasons. First, the VIE structure is used to avoid foreign ownership restrictions under the Chinese law, quote unquote, “Special Administrative Measures for Foreign Investment Access”. This law forbids foreign capital in sectors, such as telecommunications, internet, news and media being held by foreigners.
To satisfy foreign ownership restrictions legally speaking, VIEs grants no actual direct ownership of the underlying asset. So they're not a violation of Chinese law. For Chinese companies, whose businesses fall under the Foreign Ownership Restriction laws, the only way for them to attract offshore capital from private equity and other types of investors or to ultimately list overseas, is by using the VIE structure.
Second, VIEs have been used to avoid listing approval rules. Historically, Chinese exchanges have much more stringent listing requirements and the approval process takes considerably longer than it takes in the United States. To illustrate this point, neither Amazon or Facebook would have received a listing approval in China at the times of their IPOs because they didn't have the requisite profits.
Leyla Gulen (11:29):
How do VIEs enable Chinese companies to avoid listing approval rules?
Gene Reilly (11:34):
China established the rules in 1994 that require companies seeking to list overseas to receive prior approval from the State Council. The VIE structure provides a loophole because the 1994 rules do not include companies that list overseas.
From the time that Sina did the first VIE to list in the United States in 2000, the VIE structure has been used by the majority of Chinese companies in technology, media and telecommunications to raise capital by listing on US exchanges. Alibaba, DiDi, Tencent are among the many Chinese companies that have used VIEs. It's estimated that 80% of the Chinese companies listed in the US use the VIE structure.
The VIE structure has also been used by Chinese companies that have listed in the Hong Kong Stock Exchange.
Leyla Gulen (12:18):
So since VIEs have been used by so many companies over the last two decades, Chinese officials must be aware that the structure is used to avoid onshore rules.
Gene Reilly (12:29):
The Chinese officials have been aware of the VIE structure and what it did for the Chinese economy over the years. The VIE structure helped Chinese companies such as Alibaba, Tencent, Sina, Baidu and many others, raise billions of dollars it needed in offshore capital. Both, international investors who profit on their investments and Chinese companies who raised offshore capital greatly benefited from the structure over the past 20 years.
VIEs have come under regulatory scrutiny in China a number of times in the past but it's not been banned by regulators. The VIE structure was a major news topic over the past year particularly in the US. Many overseas investors have been raising concerns that China might ban the use of VIEs outright. Clarity over the use of VIEs appears to have arrived, the CSRC, the Chinese Securities Regulatory Commission published a draft of new listing rules on December 24th of 2021 that include a VIE structure for companies filing for offshore listings.
This removes the uncertainty that the VIE structure could be banned. VIEs have been officially recognized. VIEs must receive approval from the CSRC before listing overseas. This closes really, the regulatory loophole that, that previously did not require the Chinese regulatory approval. The CSRC stated that the rules would not be applied retroactively. Companies that were currently listed abroad would not be affected.
The rules also include language indicating government officials can require a company to dispose of assets or businesses if its offshore listing jeopardizes national security. The CSRC didn't say when this is becoming effective.
Leyla Gulen (14:11):
What risks are usually cited with respect to owning a Chinese stock through the VIE structure?
Gene Reilly (14:17):
The main risks of holding a VIE structure that have been cited in the past are the risks that the VIE structure will be declared invalid by China regulators or otherwise, banned. And the risk that the contractual arrangements will be unenforceable or insufficient to retain control of the VIE. Some of those risks have been removed with the CSRC's new listing rules.
However, we can imagine, a number of edge cases in which shareholders would want to enforce their claims on the assets of the company and the VIE structure has not really been tested legally to demonstrate how strong investors claims are on the assets of the Chinese onshore companies that they own via the VIE structure.
So, still many questions remain.
Leyla Gulen (15:07):
All right. We mentioned at the beginning of our discussion that there are a number of different China share classes and DiDi is currently an N-share since it's listed in the US. Now, if DiDi lists in Hong Kong, what share class will that be?
Gene Reilly (15:22):
It would become an H-share.
Leyla Gulen (15:23):
Okay. What are the reasons for the different share classes?
Gene Reilly (15:28):
That’s a great question that really requires us to think a little bit about the history of how the Chinese, equity markets have evolved, and the reasons for the different share classes.
From a China regulatory perspective, control which investor base, domestic or foreign, can access the stocks. From a Chinese company perspective, it's all about accessing capital and their ability to list. For local listings 20 years ago, there was a limited pool of capital available onshore and the listing requirements were very stringent.
In the US there is significantly more liquidity available in the capital markets. And the listing requirements for IPO, for growth capital companies, are much less restrictive.
Leyla Gulen (16:13):
Well, Gene, can the same company list on multiple exchanges or have multiple share classes?
Gene Reilly (16:18):
Yes. Some companies will list concurrently on different stock exchanges in order to reach a wider pool of investors. Companies that list on both, domestic and foreign stock exchanges will necessarily be issuing different share classes.
Leyla Gulen (16:31):
Now, we've mentioned N-shares and H-shares so far. It would be great if you could give us a complete overview of the different share classes.
Gene Reilly (16:38):
Historically, Chinese companies have had a variety of options for issuing shares in domestic and international exchanges. That's resulted in a number of different share classes. We would broadly divide them into two major categories: share classes that are incorporated inside of China and shares that are incorporated outside of China.
Leyla Gulen (16:57):
What are the share classes incorporated inside of China?
Gene Reilly (17:01):
There are A-shares, B-shares and H-shares. And the A-share market represents the majority of shares listed on Chinese stock markets. A-shares are listed on the four major exchanges. The Shanghai Stock Exchange, the Shenzhen Stock Exchange, the National Equity Exchange and the Beijing Stock Exchange.
H-shares are also widely traded by investors but they are listed in Hong Kong.
Leyla Gulen (17:26):
Okay, what about B-shares?
Gene Reilly (17:29):
B-shares were listed in 1992 as a channel for foreigners to access the Chinese equity markets. Foreigners were not permitted to invest in A-shares at that time. B-shares were, are listed on the Shanghai and Shenzhen Stock Exchanges. The majority of B-shares stocks are companies that don't have significant interest for investors so they're, they're no longer particularly relevant.
As a result of restricting B-shares to foreigners from 1992 to 2001, not many strong companies chose to go the B-share route, since there were fewer investors. But with the introduction of QFII in 2002, international investors had multiple channels to access Chinese stocks and, essentially the entire B-share concept was made obsolete.
Leyla Gulen (18:14):
Can all investors access A-shares and H-shares and B-shares?
Gene Reilly (18:21):
A-shares are open to all domestic Chinese investors who have an account. Foreign investors can access H-shares via the QFI channel or the Stock Connect channel. The Stock Connect channel doesn't provide access to all of the A-share universe and it doesn't provide access to even everything listed on either the Shanghai or Shenzhen Stock Exchanges.
The H-shares are fully accessible by foreigners just like any other developed market given that they're listed in Hong Kong. Anyone who can trade stock in the Hong Kong exchanges can buy H-shares.
Mainland Chinese investors can access the H-shares via the Connect channel on the Southbound route. B-shares are open to foreign investors and domestic investors who have foreign currency. But they are not commonly invested in buying Chinese domestic investors.
Leyla Gulen (19:13):
So what currencies are these share classes denominated in?
Gene Reilly (19:17):
The A-shares are denominated in renminbi. The H-shares are denominated in Hong Kong dollars. And the B-shares have a face value set in renminbi but actually trade in US dollars.
Leyla Gulen (19:28):
Okay. So for the three share classes that you just mentioned, A-shares and H-shares are very relevant to investors. Investors may read or hear the term B-share but they should remember that B-shares are not really relevant anymore. So now, let’s hear about the share classes incorporated outside of China.
Gene Reilly (19:49):
All the stocks incorporated outside of China are also listed outside of China and can be accessed by foreigners in the same way that foreigners can access stocks in any developed market. Both, state owned and private companies are incorporated outside of China.
Private companies issued outside of China: the main difference among private sector Chinese companies incorporated abroad is the exchange on which they're listed. Each had a different name or reference.
Leyla Gulen (20:15):
For the private companies, those share class names would be N-shares, L-shares and S-shares, is that correct?
Gene Reilly (20:23):
Yes. N-share would denote a stock that's listed in the United States, incorporated outside of China, primarily incorporated in Hong Kong and the Cayman Islands, Bermuda or BVI.
L-shares are listed on the London Stock Exchange also incorporated outside of China, most likely a Hong Kong, Cayman Island, a Bermuda or BVI or Jersey incorporation.
The S-shares are listed on the Singapore Stock Exchange, incorporated outside of China. Primarily, Singapore but also potentially the Cayman Islands, Bermuda or the BVI.
Leyla Gulen (21:01):
I've also heard the names Red Chip shares and P Chip shares used. Can you explain what those are?
Gene Reilly (21:08):
Sure. Red Chips refer to state-owned Chinese companies that conduct the majority of their business outside of China and are listed in Hong Kong. The P chip shares in contrast, refer to privately owned Chinese companies that conduct that majority of their business outside of China and are listed in Hong Kong.
Leyla Gulen (21:24):
Your very clear description of the different share classes should help investors when they hear these terms used in the future. So while we're discussing the share classes, could you explain why the price of Hong Kong listed H-shares is generally lower than domestically listed A-shares, even though the underlying company is exactly the same? I'm talking about the AH Premium. We would expect arbitrage, to keep the prices of the A-shares and the H-shares in line. However, over the years, A-shares have traded at a persistent premium to H-shares.
Gene Reilly (22:00):
It's historically been a very big pricing anomaly in the market that has attracted a lot of attention. But I think the bottom line reason why we see the difference is short selling is more difficult in China. And essentially, there's also an arbitrage. The shares are not fungible. The investor bases are different. There is a much more retail-driven market in China versus, a more institutionally-driven market in Hong Kong. There's also differences in terms of how those constituents usually react to economic data and news.
It's interesting to note that the premium is generally lower in large cap names where there is significant stock borrow available and widest on less liquid shares.
Leyla Gulen (22:49):
Gene, I want thank you so much for the informative chat. That's all the time we have for now. I'd like to thank our listeners. And we look forward to covering more topics in the future. Thanks again, Gene. We'll see you next time.
Gene Reilly (23:02):
Thank you, bye-bye.